Here’s an interpretation of the euro zone I have been meaning to run by you and I touched on it in the update to my post on how austerity in Europe works. In a fixed exchange rate environment like the euro area, you don’t have currency fluctuation issues. So persistent current account imbalances as we see within the euro zone are really a form of vendor financing. I am familiar with the perils of vendor financing having witnessed the Telecom bubble of the late 1990s go bust, wiping out the major source of revenue in the European high yield market in which I worked. Here’s an article from right around the bust that gives you a positive spin on how how vendor financing worked in telecoms.

Aerie is just one of the 45 vendor financing deals Nortel has on its books. As such, it offers a glimpse into a battle the big telecommunications equipment makers — notably Nortel, Lucent (LU) and Cisco (CSCO) — are rushing to join: picking up more of the financing slack for the very companies that buy their equipment.

Islands in the Stream

While Nortel is certainly knee-deep in the lending business, rival Lucent is the true champion of vendor financing. Lucent has been saying "yes" ever since it hit the ground four years ago, to the tune of $7 billion in financing commitments, more than double Nortel’s $3.1 billion. (Nortel has $1.4 billion in actual loans outstanding to buyers of its equipment; Lucent, $1.6 billion.)

Cisco, in order to compete with the incumbent telecom equipment makers, says it has beenincreasing its vendor financing activities through its banking arm, Cisco Capital. Cisco has so far promised $2.4 billion in loans to its customers. (Cisco’s loans outstanding amount to $600 million.)

Equipment makers derive several advantages from so-called vendor financing arrangements, the terms of which often remain under wraps. Namely, they gain relationships with potentially lucrative customers and revenue that will look good on the next financial statement.

Vendor financing works successfully as long as the lender makes sure the customer can pay back the loans. In the telecoms arena, the whole sector cratered and these loans were an albatross around the necks of the likes of Nortel and Lucent. Not only did firms like Nortel lose huge revenue streams, they also had to write off massive amounts of capital from dud loans they had made to customers during the bubble. It’s as if most of the revenue Nortel and Cisco were booking in 1998 or 1999 was phantom revenue, maintained artificially by their channel stuffing and vendor financing of customers. Eventually Nortel went bankrupt.

And so it is in Europe as well. The lurid Telegraph story about German-made Porsches bought in Greece shows you an extreme example of how this works. The reality is you can’t have Germany and Spain both running current account surpluses with each other at the same time. Unless the euro zone as a whole runs a current account surplus as large as Germany and the Netherlands, then you are automatically going to have a sort of vendor financing relationship going.

The euro area did have a good-sized trade surplus through 2005 – not as large as the one that Germany and the Netherlands had, but sizable. This all unravelled starting in 2005 (chart below via tradingeconomics.com). That would have been the time for German banks and companies to pull in their horns and restrict credit to the periphery.

So, if Germany or the Netherlands wanted to be the export juggernaut and run a massive current account surplus, this had intra-EU ramifications. The most important is that Germany’s or the Netherlands’ current account surplus matched current account deficits in Spain, Portugal, and Greece. That’s how it works. You sell more to me than I do to you and I get more cash than you do. There are always two sides to every transaction (chart from the FT below).

The large euro-area internal current account imbalances should be seen as a form of vendor financing, whereby the creditors, principally Germany, forward their customers, the debtors, trade finance in order to sell their wares. Germany’s aging society meant slow growth. So German companies have looked abroad for growth, just as the Japanese have done in their aging society. Taken in aggregate, this means persistent current account surpluses which are a fancy way of saying vendor financing at the national level.

German banks were at it too, by the way. German retail banking is a low margin business and credit growth is weak. So the German banks loaded up on foreign assets, making loans abroad. German banks were very active in Ireland and Spain during the housing bubbles there, for example.

So, one way to look at the sovereign debt crisis is a complicated form of vendor financing. German banks have been particularly aggressive in seeking returns abroad and now the chickens are coming home to roost.

Edward Harrison is the founder of Credit Writedowns and a former career diplomat, investment banker and technology executive with over twenty years of business experience. He is also a regular economic and financial commentator on BBC World News, CNBC Television, Business News Network, CBC, Fox Television and RT Television. He speaks six languages and reads another five, skills he uses to provide a more global perspective. Edward holds an MBA in Finance from Columbia University and a BA in Economics from Dartmouth College. Edward also writes a premium financial newsletter. Sign up here for a free trial.

I personally worked out the bad vendor financing deals at LU from ’03 – ’05 (have a lot of stories!!), so I know what you are talking about here! It does make sense….and German export order plummeting in September confirms the story.

Either ECB goes all in (I still see this as the outcome as German politicians and central bank buckle when really really pushed to a corner by Italy and maybe France!) or Eurbonds (which I don;t see happening).

I think the ECB will have to go all in because of Italy. And if it weren’t Italy eventually it would be France. It’s an institutional thing really. The euro zone needs a lender of last resort. The Germans and the ECB don’t want to have this lender though because they want the ‘profligate’ countries to practice better fiscal discipline across the business cycle.

It’s this mentality which is at odds with the very vendor financing we are discussing that creates a problem for the euro zone. The current accounts, private savings and government deficits are all inter-related. You can’t change one without having an impact on the others, domestically and abroad. The people fixated on the fiscal side of things are not cognizant of the inter-relationship. I know I was not thinking about it three years ago.

The only way to rein in deficit spending is through greater fiscal integration. You have to give up sovereignty if you want the benefits of the common currency without the negatives. there’s no way around it. People are learning this, but too slowly.

I am friends with the guys over at Mercenary Trader and Jack Sparrow been saying the same thing for a while. I totally agree with this Vendor financing idea.

If you follow de Spiegle (what am I saying – you read it in German!) when they started pushing back on the euro breakup back late last year, you can see this said almost word for word by major business heads in Germany. They are quite frank about it.

This is why I am so shocked at how Germany seems determined to push Greece off the political cliff.

I used to do be in the equipment business in the 90’s and the common assumption in the international market was that vendor financing would be available from the German and Japanese manufacturers–in my mind, it was a huge part of their competitive edge (the necessary bribes could be hidden there as well). Easy credit was just another part of their industrial policy.

I always wondered who would be on the hook when the loan went bad. . .

If this crisis is nothing more than vendor financing then the lenders should take their losses. Longer term could this be resolved by having a EU tax on the net balance on the country with a net positive position. So If Germany had a consistent balance surplus with Greece of €1 billion then it should pay a “tax” of 40% (of the €1 billion) to Greece. This could be used as a quick alternative to fiscal transfers which seem bogged down in nationalism right now. That would solve the trade imbalances.

Then add in bans on banks operating outside the country of incorporation. So Germany could not lend to Greece, except via its Greek subsidiary. So if this had been the case when the crisis hit the losses would be taken within the Greek banks entirely. Though the german banks would have to take losses on the bankruptcy of their greek subsidiaries. This would eliminate contagion, and regulation arbitrage.

The “tax” could be a quick alternative to fiscal transfers. Though I do agree that fiscal transfers are the permanent solution but even within a nation there can be long term problems if the fiscal transfers do not allow the recipient to become more self financing. Here in the UK the Conservative government are slashing transfers to the north of the country because they claim that public sector jobs are crowding out private sector job creation. Complete rubbish but since they did not vote for the government this could be viewed as simple retribution. This could happen with the recipient countries eventually especially given the attitude of the Germans and Finns.

Well if the Germans had regulated the loans that their banks made all across Europe we would not have a series of bail outs. Where do you think that the majority of the bail out funds went? A lot has flowed back to Germany. Its banks are probably insolvent and you preach to the rest of the world about living within your means. Yes there are significant problems across the periphery. Most Greeks lived within their means, they just did not pay taxes because the super rich were given a no tax thank you for “helping” Greece. Ireland was never going to avoid a property bubble with cheap funds of the eurozone. The government and central bank ignored the bubble and put it down to their amazing skills and hard work. Asset bubbles are just that. Bubbles no matter what it is, It distorts investment and no government has sensible laws or taxes to deal with that problem. Germany funded that Irish property bubble with more than €100 billion.

So Greece Ireland Italy Spain and Portugal all made mistakes but all funded with German money. Only this week Siemens Finance have been involved in a fraud in the UK. Hardly the actions of a well run bank.

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